Cass Business School research makes the case against pure passive investing based on market weighted indices

3rd April 2013

The Cass Business School has thrown a cat amongst the passive investing pigeons and maybe a monkey to boot. In a research report using 43 years of US equity market data, the report authors created 13 alternative indices rather than the current conventional market cap weighted index. All outperformed.

Report author Dr Nick Motson of Cass Business School said: “All of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index.”

But Cass also found that equity indices constructed randomly, by computers (it suggests therefore they could have been constructed by monkeys in its press release) would have produced higher risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years.

The study based on monthly US share data from 1968 to 2011 found nearly all 10 million indices weighted by chance delivered vastly superior returns to the market cap approach. Cass says the discovery likely to come as a blow to investors that have billions invested worldwide invested on a market cap-weighted basis.

Co-author, Professor Andrew Clare, says: “We programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample; we effectively simulated the stock-picking abilities of a monkey.  The process was repeated 10 million times over each of the 43 years of the study.

“The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques.  However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted indices. One of the implications of our work is that we should perhaps be benchmarking our fund managers against monkeys rather than against a cap-weighted index!”

John Belgrove, Senior Partner at Aon Hewitt which commissioned the report, said: “There has been a glut of so-called ‘smart beta’  investment products coming to market in recent years and we are keen to see some consistent academic rigour to help investors better understand some of the opportunities and risks available to them in this space. I believe the work Cass has carried out in association with Aon Hewitt will be of considerable interest both to investors and to the fund management community. While market capitalisation weighted benchmarks remain the bedrock to performance assessment and portfolio construction, this work sheds fresh light on the age- old active/passive industry debate.

“Inherent weaknesses in cap-weighted investment strategies are well documented, although they have been an enduring and challenging benchmark for active managers to beat. The long run results of the monkeys are therefore likely to cause some surprise and we welcome further debate. The good news for investors is that there is more implementation choice than ever to consider when selecting a preferred long term portfolio construction and fund manager style.”

Out of the alternative indices, the sales-weighted index performed the best, beating 99 per cent of the monkeys’ randomly constructed indices.

The report is called ‘An evaluation of alternative equity indices.  Part 1: Heuristic and optimised weighting schemes’ and ‘An evaluation of alternative equity indices. Part 2: Fundamental weighting schemes’ by Professor Andrew Clare, Dr Nick Motson and Professor Steve Thomas of Cass Business School.  The links to the two papers are here – Paper 1 and Paper 2.

Mindful Money view:  The report may bring another dimension the passive/active debate. It certainly highlights that most forms of passive investing are using someone’s methodology for selecting the components i.e. whoever decided the formulation for creating an index whether its the FTSE, S&P or the Nasdaq though there are a host of alternative indices out there. We will watch this debate with interest to see if passive managers respond or engage with the arguments made here. A lot of passive investors, or passive advocates among financial advisers will say they are very doubtful not just about active fund managers’ ability to beat the index certainly net of charges, but also even if some can, they are unsure about their ability to select the right one. That is certainly one point of view often made very forcefully. But what if it’s not the correct index either? Is it passive plus or something else entirely. We don’t have any easy answers but we suggest watching this debate with interest.


Leave a Reply

Your email address will not be published. Required fields are marked *